Big Trouble in Big China?

The Chinese stock market and the Chinese economy are perplexing. The latter seems to be slowing rather dramatically, and there is widespread belief that the growth rate is, or soon will be, far below the 7 percent level the government is touting. Nonetheless, the stock market has been skyrocketing, with some periodic selloffs as occurred yesterday.

The government is allegedly intent on transitioning from the investment- and export-driven growth model towards a more consumption-oriented one: Fixed investment as a fraction of GDP is at stratospheric levels, and consumption as a fraction of GDP is extremely low. Its ability to navigate this transition, due to the inherent difficulties of trying to manage a huge economy as well as the political economy factors that tend to impede change, is open to serious doubt. There is always the possibility that the government will respond to any growth slowdown the way it has in the past, through massive stimulus.

Further, the strength of the Chinese banking sector is always open to question. If the government (and the central bank) are concerned about it, that would also tend to bias them towards loosening credit.

Local governments are connected to all these issues. Local governments, through so-called Local Government Funding Vehicles, fund a substantial fraction (about 20 percent) of Chinese investment. These entities have exhibited signs of financial distress, as indicted by high yields. This reflects the dodgy quality of many of the investments these vehicles funded. This is a problem for Chinese banks, which have a large exposure the LTFVs.

The Chinese government recently provided a very strong indication that it is indeed deeply concerned. It announced a set of measures that look for all the world to be a financial shell game intended to move local government risk onto the balance sheet of the People’s Bank of China and simultaneously create credit.

As originally announced, the banks were expected to swap LGFV debt for municipal bonds carrying a lower interest rate. The banks were obviously unenthusiastic about this, and the takeup was minimal. So the PBOC made it plain that this was not voluntary: banks were expected to buy the lower interest munis. To induce them to do so, the PBOC said that it would permit the banks to post these securities as collateral at the central bank, and use the proceeds of the collateralized borrowing to extend new loans.

The exact nature of the collateralized borrowing from the PBOC is about as clear as a Beijing sunset, but it is evident that this mechanism can serve as a way of passing the muni credit risk onto the PBOC. If the munis become distressed, and the loans are de jure or de facto non-recourse, the banks default on the loans, leaving the PBOC with the bad local government debt.

It is clear that this is a bailout of the local governments. They are now borrowing at below market rates: it wouldn’t have been necessary to coerce and induce the banks to buy the local government debt if they were sold at rates reflecting the credit risk. Since the banks now appear willing to lend, they must believe that the central bank is wearing the risk, and hence paying the subsidy. In other words, the pea is under the shell labeled “PBOC.”

The command that that banks lend the proceeds from the loans from the PBOC means that the overall effect of the program will be to expand bank balance sheets and increase credit. It is both bailout and stimulus.

Putting this all together, this suggests that the Chinese authorities are deeply concerned about the financial condition of local governments and the banks, and is also deeply concerned about growth prospects. It could also indicate hesitation about transitioning away from the investment/export-driven model. All of which makes the booming Chinese stock market all the more puzzling. Unless, that is, the betting is that the government will respond to weak growth by resuming the credit stimulus and blowing asset bubbles.

None of this are signs of a healthy economy, or healthy markets. It is instead symptomatic of massive distortions and imbalances produced by years of heavy-handed policies. The imbalances must correct eventually, but the Chinese are saying not yet, lord, not yet.

But they cannot defer the reckoning forever, and the longer it is delayed, the more brutal the correction will be. But like politicians everywhere, the current Chinese government no doubt is content that the blow up occur on the next guy’s watch.

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.